In the investing community, there are many different philosophies and strategies, but the two schools of thought that constantly come up are the differences between investing for equity and investing for cash flow.  Equity is the value of an owned interest in a property, while cash flow is the monthly income that a property provides. In this post, we will look at some examples demonstrating why investing for super charged cash flow is a more beneficial and provides a better buffer for your portfolio.

Recently, I had a discussion with an experienced investor who swore by his strategy of purchasing houses with loans that amortized in 15 years, as opposed to 30 years.   In this scenario, he explained he was investing for equity in the properties and once the loan was paid off, the cash flow will be strong because none of the cash flow will go to debt services.  His point was that not only do 15-year mortgages have lower interest rates, also; because the property owner pays the debt off quicker, he ends up paying less interest on the loan.  Let us look at  an example of how the two mortgages make a difference:

For this example, we will use a rental property in Memphis, Tennessee that rents for $1,000 a month, with a 40% Operating Expense. (Of the $1,000 in rent, $400 will go towards Property Management, Property Taxes, Insurance, and Miscellaneous Expenses, and $600 will be the Net Operating Income.)

15 year Mortgage

House Price: $100,000

Down Payment: 20%

Interest Rate for 15 year: 3.625%

Payment: $576.83

Total Dollars Paid Once Loan Is Paid Off: $576.83 x 180 = $103,829.29

30 year Mortgage

House Price: $100,000

Down Payment: 20%

Interest Rate for 30 year: 4.375%

Payment: $399.43

Total Dollars Paid Once Loan Is Paid Off: $399.43 x 360 = $143,794.15

As you can see, because the homeowner is paying the mortgage for an extra 15 years on the 30-year mortgage, he will pay $43,000 more in total dollars towards the loan. This was one of the equity investor’s main points. However, let’s look at some other numbers that show fallacies in this strategy…

Cash Flow Calculation:

15 year mortgage: $600 (Net Operating Income) -$576.83 (Payment)=  $23.17 = Monthly Cash Flow

30 year mortgage: $600 (Net Operating Income) – $399.43  (Payment) = $200.57 = Monthly Cash Flow

Because the 15-year payments are so high, the property is barely cash flow positive, while the 30-year mortgage will provide the investor with a solid $200 in monthly cash flow.  The reason this is important is because the 15-year loan leaves NO margin for error.  Financial planning is about allowing buffers into your numbers and having a $23.17 monthly buffer is about as small as mathematically possible. Furthermore, say the value of the property decreases, that’s the entire investment down the drain! You cannot control what markets do, but if you are getting strong cash flow, you don’t care! Let’s say, for instance, after renting the property for ten years, values decrease and vacancies start rising. With a 15-year mortgage you would have made a whopping $2,780 in cash flow. With a 30-year mortgage, you have already made $24,068 in cash flow and therefore, gotten your $20,000 down payment back!

Because I am cash flow focused, I would rather take advantage of the longest-term loans possible to super charge my returns and minimize my risk by getting higher cash flow as soon as possible. However, in all fairness, this subject is complicated and investors’ strategies can vary for a vast array of circumstances.

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- Hunter Thompson